Tuesday, November 16, 2010

Standard monetary policy is about setting short-term nominal interest rates. Most macroeconomic models assume that inflation is sticky (constant) in the short run and by moving nominal interest rate the central bank is actually setting the real interest rate and by doing so influencing spending (consumption and investment) decisions. Of course, these spending decisions might depend on long-term interest rates and therefore we also need to understand how short-term interest rates affect both nominal long-term rates and inflation over a longer horizon (where we cannot assume that inflation is constant).

We can use this logic to think about the most recent quantitative easing policies announced by the Fed. That's what Mark Thoma does very well today in his blog. One issue that I am missing in his analysis is how we think about real interest rates (not just nominal) in the current context. This is very much related to the defense that some Fed officials have done over the last hours of their policies. For example, in his interview with the WSJ, Janet Yellen argues that QEII (the next round of quantitative easing) is not intended to raise inflation. That the Fed is happy with an inflation rate below but close to 2%.

I understand the importance of having a "low and stable" inflation target but we need to keep in mind that these targets should be interpreted in a medium-term framework, we are not asking the central bank to deliver a constant 2% inflation every month, quarter or year. And given that the Fed has refused to adopt a formal inflation target to keep its flexibility to set inflation on a short-term basis, why do they seem so obsessed with ensuring that inflation always stays at or below 2%? Even the ECB that is some times seen as putting too much emphasis on inflation has let the Euro inflation rate go above 2% during many of the months it has been in existence, so a little flexibility above 2% in the communications of the Fed might not hurt.

We can also think about what all this implies for real interest rates, by asking: what should the level for real interest rates be given current economic conditions? We know that with short-term rates at zero (and they cannot go lower)sending a strong message about inflation being below 2% sets a floor for how low real interest rates can go (the floor is -2%). Estimates of what the appropriate real interest rate is in the current situation (which tend to be made within the context of a Taylor rule) vary but some suggest that real interest rates might need to be even lower than that [By the way, I find this related post by Krugman very useful to understand the logic behind negative real interest rates].

In addition, we have the issue of the dynamics of expectations and actual inflation. It might be that Fed officials by sending a very strong message about not wanting to increase the inflation rate above 2% will keep inflation expectations low and actual inflation remains significantly lower than the 2% "target". My guess is that their conservatism when it comes to inflation is the results of the strong criticisms that they have received (both at home and abroad), which has sent them into a defensive position where they need to reassure everyone that their current policies are not about raising inflation. But this might not be optimal, while anchoring long-term expectations of inflation around a low target is reasonable, there is nothing wrong in admitting that one of the goals of the current policy is to ensure that inflation stops falling and that we go back towards 2% or even higher in the short-term.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).